By Susan Barreto
Diversification isn't what it used to be. The basic concept
of diversification, the putting of money to work in as many
asset classes as possible to dampen the overall portfolio risk,
seems to have done a negligible job in saving pension funds
from going broke.
But for all the diversification talk between 2000 and 2008,
why did all pensions, no matter their asset mix, seem to lose
out equally? Is diversification a pensioner's myth?
This is a question recently raised in Steven Drobny's book
called The Invisible Hands - Hedge Funds Off the Record -
Rethinking Real Money. Drobny, well known for his interviews of
global macro hedge fund managers, decided in the final chapter
of his new book to interview a pension manager.
Anonymously, "The Pensioner" in Drobny's book claims that
2008 showed how the classic mix of 60% stocks and 40% bonds was
akin to significant equity exposure and even the alternative
investment "non-equity" assets turned out to be very
equity-like in their behaviour.
The reaction to the equity overload prior to 2008 has
broadly translated into a decrease in equity investments and a
boost to the alternatives portfolio. A recent example of this
can be found at the New Jersey Division of Investment (page
Meanwhile, North Carolina is trying to decide if
diversification is worth it if the allocation is small (page
8). According to consultant Ennis Knupp, further analysis
regarding the optimal use of hedge funds, and documenting their
use in the investment policy, would benefit the North Carolina
Was it only slight of hand, or are pension executives
actually finding the prize in the asset management shell game
that began in 2008? Has it really taken until 2010 for pension
funds to move to remedy the unforeseen illiquidity, market
correlation and group think strategies that caught them so off
guard in 2008?
The discussions in New Jersey and North Carolina are what we
have traditionally seen as pensions find their funding status
improve in rising markets - or a proactive rebalancing if you
But the next step is much more daring and is akin to picking
up all the shells in the game to find money under all three to
the delight of the gambler.
So-called 'risk parity leverage' seems to have found a
following among a growing group of US public pension plans. For
example, the Ohio Police and Pension Fund portfolio will be
levered 1.2 times, which is expected to reduce risk by 91 basis
So, maybe leverage is now equal to diversification of old as
the way to cure an ailing portfolio?
Leverage can be used to improve the diversification of a
smaller pension portfolio by levering up low-volatility assets
and levering down the risky assets. The caveat is that the
pension programme needs to significantly improve the risk
management system for it to really reduce risk. Remember, risk
measurement is not risk management - whatever anyone tells
In the words of Drobny's Pensioner: "The difference in
expected return at the same level of risk between the levered
diversified and unlevered undiversified portfolios can be
substantial, potentially 2% per annum under realistic
The argument goes that portfolios that are diversified and
unlevered will increasingly fall behind too. The ability of all
pension plans to employ such an approach is hindered by the
public's perception of the role of leverage and derivatives in
the 2008 crisis, and it remains to be seen whether a new model
of diversification will cure the global pension fund
There is no doubt though that going forward modern
pensioners must include at the very least hedge funds in the
optimal asset mix.